Enterprise and Individual Risk Management v. 1.0 This is the book Enterprise and Individual Risk Management (v. 1.0). This book is licensed under a Creative Commons by-nc-sa 3.0 (http://creativecommons.org/licenses/by-nc-sa/ 3.0/) license. See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and do make it available to everyone else under the same terms. This book was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz (http://lardbucket.org) in an effort to preserve the availability of this book. Normally, the author and publisher would be credited here. However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed. Additionally, per the publisher's request, their name has been removed in some passages. 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You can browse or download additional books there. ii Table of Contents About the Authors................................................................................................................. 1 Acknowledgments................................................................................................................. 6 Dedications............................................................................................................................. 7 Preface..................................................................................................................................... 8 Chapter 1: The Nature of Risk: Losses and Opportunities ......................................... 11 Links .............................................................................................................................................................. 15 The Notion and Definition of Risk.............................................................................................................. 17 Attitudes toward Risks ................................................................................................................................ 23 Types of Risks—Risk Exposures .................................................................................................................. 27 Perils and Hazards ....................................................................................................................................... 41 Review and Practice..................................................................................................................................... 48 Chapter 2: Risk Measurement and Metrics ................................................................... 50 Quantification of Uncertainty via Probability Models............................................................................. 54 Measures of Risk: Putting It Together ....................................................................................................... 70 Review and Practice..................................................................................................................................... 88 Chapter 3: Risk Attitudes: Expected Utility Theory and Demand for Hedging ..... 91 Utility Theory ............................................................................................................................................... 96 Uncertainty, Expected Value, and Fair Games........................................................................................ 100 Choice under Uncertainty: Expected Utility Theory.............................................................................. 105 Biases Affecting Choice under Uncertainty ............................................................................................ 114 Risk Aversion and Price of Hedging Risk................................................................................................. 121 Information Asymmetry Problem in Economics .................................................................................... 126 Why Corporations Hedge .......................................................................................................................... 133 Review and Practice................................................................................................................................... 136 Chapter 4: Evolving Risk Management: Fundamental Tools ................................... 140 The Risk Management Function............................................................................................................... 146 Beginning Steps: Communication and Identification ............................................................................ 150 Projected Frequency and Severity and Cost-Benefit Analysis—Capital Budgeting ............................157 Risk Management Alternatives: The Risk Management Matrix ...........................................................163 Comparisons to Current Risk-Handling Methods................................................................................... 170 Appendix: Forecasting............................................................................................................................... 174 Review and Practice................................................................................................................................... 178 iii Chapter 5: The Evolution of Risk Management: Enterprise Risk Management .. 180 Enterprise Risk Management within Firm Goals.................................................................................... 184 Risk Management and the Firm’s Financial Statement—Opportunities within the ERM ..................191 Risk Management Using the Capital Markets ......................................................................................... 200 Chapter 6: The Insurance Solution and Institutions ................................................. 219 Links ............................................................................................................................................................ 220 Nature of Insurance ................................................................................................................................... 222 Ideal Requisites for Insurability ............................................................................................................... 231 Types of Insurance and Insurers .............................................................................................................. 242 Appendix: More Exposures, Less Risk...................................................................................................... 253 Review and Practice................................................................................................................................... 255 Chapter 7: Insurance Operations................................................................................... 256 Insurance Operations: Marketing, Underwriting, and Administration ...............................................259 Insurance Operations: Actuarial and Investment .................................................................................. 275 Insurance Operations: Reinsurance, Legal and Regulatory Issues, Claims, and Management ..........296 Appendix: Modern Loss Reserving Methods in Long Tail Lines............................................................302 Review and Practice................................................................................................................................... 309 Chapter 8: Insurance Markets and Regulation........................................................... 311 Insurance Market Conditions ................................................................................................................... 315 Insurance Regulation................................................................................................................................. 326 Review and Practice................................................................................................................................... 346 Chapter 9: Fundamental Doctrines Affecting Insurance Contracts ....................... 348 Agency Law: Application to Insurance .................................................................................................... 352 Requirements of a Contract ...................................................................................................................... 361 Distinguishing Characteristics of Insurance Contracts ......................................................................... 364 Review and Practice................................................................................................................................... 380 Chapter 10: Structure and Analysis of Insurance Contracts ................................... 382 Entering into the Contract........................................................................................................................ 385 The Contract............................................................................................................................................... 389 Review and Practice..................................................................................................................................